We shared this story of the Monkey in the Buddhist book Journey to the West.. he had to overcome various obstacles with the team in the journey of knowledge and education, including the powerful Centipede who had a thousand eyes that shone on Monkey, searing him very badly.. Badly hurt, he sought the help of Goddess of Mercy who directed him to Mother Hen god fairy who in turn passed him a special gift/weapon: the Needle. When the Centipede uses the thousand eyes again when they meet, Monkey uses the Needle which worked its way by poking the thousand eyes.
From the Buddhist interpretation to the book Journey to the West, this story is about how when we are accused and bullied by a powerful person who would use all sorts of diversionary tactics and scrutiny (eyes and mouths) to destroy us, the only way is the Needle, which stands for the Truth in public.
Consider this: A company uses cash to buy government bonds, subsequently depositing the bond in a bank, a seemingly very harmless transaction. Is this potential accounting fraud?
What is undisclosed is this company, Olympus, colluded with the LGT bank manager to use the bond as a collateral to lend to two shell companies created by Olympus. These shell companies then use the borrowed money to acquire toxic assets at cost from Olympus, thus allowing Olympus to avoid recognizing impairment losses on these underwater securities should they be marked to market in both the immediate period and in the long-term.Thus, Olympus was able to transfer losses of over ¥96bn to the shell vehicles, enabling Olympus to separate unrealized losses from its consolidated financial statements. Note that there was no real cash outlay for this scheme and the cash position of Olympus did not change, because the amount it would provide as collateral to the banks would be returned by the shell vehicles once they purchased the toxic investments from Olympus. Olympus was able to swap the toxic assets for high-quality Japanese government bonds held as collateral by the lender. The toxic investments were held by tobashi or unconsolidated receiver funds that could bide time and wait for the value of these investments to rebound. If that were to happen, the shells were to liquidate these investments and repay the loans to the lenders, thereby releasing Olympus’ collateral at the banks
This carried on for not just one or two years. But as long as seven years. After years of carrying the loans to the shells, the lenders demanded repayment. Even after seven years after transferring the toxic assets to the shells, their values had not rebounded. Olympus then carried out the dubious related-party M&As at inflated valuations, and all the books/articles/news talked solely about these fraudulent acquisitions, without tracing back to the original accounting transgression of the seemingly harmless transaction of the shifting of cash into bond placed in a subsidiary and deposited in a bank. If the related-party lending relationship between Olympus and the shells is disclosed, under IFRS, there is a financial liability recorded in the balance sheet that would dramatically reduce the shareholders’ equity.
Olympus is a tough case for accounting and forensic “experts” because (1) it is a prominent and reputable company with magazine cover stories profiling its achievements and success, and many would reasonably equate visibility and media coverage to that of a “good” company; (2) it does have genuine customers, world-class technology and products, and global market leadership in medical/biotech products, and (3) it has prominent sophisticated intelligent institutional investors who have done their proper due-diligence on the company’s publicly audited accounts. The Olympus case is unlike the typical fraudulent S-chips or P-chips with no genuine quality asset and customers. The Olympus case highlights the fact that business visibility and prominence, and the representation of firm performance in accounting numbers, are two different matters. Olympus has fraudulently misrepresented and exaggerate its firm performance and underlying economic health in the accounting numbers. Note that the unraveling of the accounting fraud does not mean that the products and services provided by Olympus are not good. In fact, this is worse especially if the good medical product and service to benefit their patients are compromised in the long-run as a result of their accounting transgressions.
There is a consistent analytical framework and common pattern behind the multiple actual accounting fraud cases that we can apply and adapt to examine potential cases. Some of these red flags centered around the related party transactions (RPTs), the unusual flow of funds amongst subsidiaries, associates, JVs, and corporate investments that are captured in footnote items that include “other receivables”, “cash equivalents”, “amounts due to/from subsidiaries”, “investment in subsidiaries”, “eliminations in inter-segment balances”, “unsecured and interest-free loans, advancements, prepayments”, undisclosed loan guarantees, “other payables”, free cashflow negative position with dividends and cashflow from operating activities funded by cashflow from financing activities from raising funds from external equity and debt, etc. If Case A, Case B, Case C of actual accounting fraud cases have such patterns and red flags, it is reasonable that a company with similar patterns and red flags, especially if there is insufficient accounting disclosures and transparency on the RPTs, accounting estimates, accounting policies, bears the responsibility and onus in its positive constructive engagement and communication with its minority shareholders as part of its fiduciary duties.
Revenue and earnings management (and stock trading manipulation/insider trading) have been documented in various empirical research findings (eg Dechow, Sloan and Sweeney, 1996, CAR) to be associated with subsequent accounting fraud. With the Olympus/Satyam case and various other cases involving even bigger corporate leaders that misled even the world’s best accounting expert and investor (eg Tesco and Warren Buffett’s investment in Tesco), it will be entirely irresponsible for any accounting educator to proclaim that there is the certainty of no potential accounting fraud taking place at companies with similar patterns and red flags, especially if there is insufficient accounting disclosures and transparency on the RPTs, accounting estimates, accounting policies.
What is a reasonable and common-sense acid test for potential “fraud”? Only after it has happened, when it is too late, as always? For Users of financial statements, above and beyond the audited “true and fair view”, if researchers and investors cannot write a single sentence or paragraph of accounting issues at SMEs such as Sheng Siong, Vicom, but can find plenty of accounting issues at certain companies that runs into pages, this means that the only proper, responsible and positive solution for the company is to improve accounting disclosure and transparency to account to the public and regulators.
It will be dark days ahead for the millions of minority shareholders, educators, researchers if the regulators/government and the long arms of justice were to not adapt a firm, proactive, before-it-blows-up, stance and action in protecting the interest and billions of hard-earned assets of the public/minority shareholders and ensuring a fair and orderly capital market for participants. This means a hard look into what is potential accounting fraud beyond a post-mortem analysis of internal control weaknesses with a capital market perspective by focusing on the multiple accounting issues and red flags highlighted, and a reasonable and common-sense request for greater transparency and accounting disclosures on the RPTs, accounting estimates, accounting policies, as well as unusual stock price and volume movement and manipulation prior to and around important publicly-announced capital market transactions.